REBLOG: The Rule of 20 Can Make You Plenty

Today, we want to share a post with our followers that was recently published by Wade Slome, CFA, CFP® on his website Investing Caffeine discussing P/E ratios and the current yields on equities in relation to the current yields on bonds (link to original article). We want to thank Wade for allowing us to share this with everyone, and we hope you enjoy his thoughtful insights.

There is an endless debate over whether the equity markets are overvalued or undervalued, and at some point the discussion eventually transitions to what the market's appropriate P/E (Price-Earnings) level should be. There are several standard definitions used for P/Es, but typically a 12-month trailing earnings, 12-month forward earnings (using earnings forecasts), and a multi-year average earnings (e.g., Shiller 10-year inflation adjusted P/E - see Foggy P/E Rearview Mirror) are used in the calculations. Don Hays at Hays Advisory provides an excellent 30+ year view of the historical P/E ratio on a forward basis (see chart below).

Blue Line: Forward PE - Red Line: Implied Equilibrium PE

If you listen to Peter Lynch, investor extraordinaire, his "Rule of 20" states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of approximately 18x times earnings when the current 2011 P/E multiple implies a value slightly above 11x times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.

Just because prices have been chopped in half, doesn't mean they can't go lower. From 1966 - 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from about 800 to almost 14,000 in 25 years. Even though equities have struggled at the start of this century, a few things have changed from the market lows of 30 years ago. For starters, we have not hit an inflation rate of 13% or a Federal Funds rate of 20% (~3.5% and 0% today, respectively), so we have some headroom before the single digit P/E apocalypse descends upon us.

Fed Model Implies Equity Throttle

Hays Advisory exhibits another key valuation measurement of the equity market (the so-called "Fed Model"), which compares the Treasury yield of the 10-year Note with the earnings yield of stocks (see chart below).

Blue Line: 10-Yr Treasury - Red Line: Forward PE

Regardless of your perspective, the divergence will eventually take care of it in one of three ways:

1.) Bond prices collapse, and Treasury yields spike up to catch up with equity yields.

At the end of the day, money goes where it is treated best, and at least today, bonds are expected to treat investors substaintially worse than the unfaithful treatment of Demi Moore by Ashton Kutcher. The Super Committee may not have its act together, and Europe is a mess, but the significant earnings yield of the equity markets are factoring in a great deal of pessimism.

The holidays are rapidly approaching. If for some reason the auspice of gifts is looking scarce, then review the Fed Model and the Rule of 20, these techniques may make you plenty.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC "Contact" page.

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